MAKING CENTS: Tax alpha for your portfolio and estate

By John NapolitanoFor The Patriot Ledger
Posted Aug. 23, 2014 at 1:00 PM

» Social News

In these columns, I try to avoid jargon or any technical term that came from your high school Latin class. But this week, I am going to break my own rules and write about a term that is frequently bantered about in professional money management circles.

The concept is tax alpha, making sure that your investment strategies have the right combination of holdings so that the income tax consequences of the actions inside your portfolio do not materially reduce your investment returns.

Many investors have a combination of holdings. Some of your investable assets are likely held in qualified plans, such as IRAs or 401ks, where the income tax consequences are a moot point until the money is withdrawn. In addition to money in retirement plans, many investors also have a taxable collection of investments where income taxes are due each year from the income or capital gains generated from those holdings.

The most basic form of tax alpha would have investors owning all holdings that generate current taxable income, such as interest or dividends, inside their retirement plans to the largest extent possible. If you are a balanced investor where your portfolio is comprised of a combination of fixed income and equity based holdings, consider using the qualified bucket to hold all of the tax unfriendly investments.

When filing tax returns, if your schedule D is long and the tax consequences of your portfolio cost you more in taxes than you’d like, a little tax alpha analysis may help. Begin by examining the nature of the tax consequences. If the tax issues are from a significant amount of trading, consider a different strategy. If the tax consequences are from investment distributions or partnerships that you own, consider alternative holdings with fewer annual distributions.

A good way to start the tax alpha process is to take inventory of your portfolio and the anticipated tax consequences for the end of the year as soon as possible. By doing this now or sometime early in the fourth quarter you’ll be able to see, and perhaps forecast the tax consequences of your holdings. From this point, you may be in a position to favorably alter the tax consequences and maximize your after tax returns.

Page 2 of 2 - Tax alpha isn’t just something that is done on a year by year basis. Your estate plan may also benefit from a little income tax planning – even if you are young and healthy. For example, many parents leave their assets in amounts to be equally distributed to their children. But when this comes to retirement or or other tax-deferred accounts, a little advanced tax planning may make sense. If you have large retirement accounts for example, make sure that you assess the after tax consequences of that inheritance to the next generation. If you split your estate equally among your children, it would be helpful to understand the after tax consequences to them now to avoid an unequal after tax situation later.